Young people’s secret weapon

Servaas van Bilsen is assistant professor of actuarial science and mathematical finance at Tilburg University (NETSPAR) and the University of Amsterdam. His research interests include pension economics and behavioral finance.

Ask a lecture hall full of students if any of them have ever thought about their old-age pension. Many of them will probably say: “Why worry about that now?” Which is a pity, because the opposite is actually true. Your pension is very much something to look into at a young age. Why, you may ask? Well, because young people have a secret weapon that older people do not have: they have their whole working lives ahead of them and can profit from this if they play their cards right.

Let us suppose you made 2,000 euros working a part-time job. You could spend this money on a trip to a far-away tropical island. If you choose a holiday destination like that, the money you earned will likely be gone by the time your holiday is over. Alternatively, you may choose to go on holiday closer to home – let us say, to a campsite in southern France. If you choose this option, you will probably only spend half of the 2,000 euros you earned. You can save the remaining 1,000 euros for your retirement. Your savings will substantially grow of time. If you are young and have another 45 years of working ahead of you before retiring, you will end up with 9,000 euros, assuming an annual rate of return of 5%. Do you think 5% is high? Well, pension funds have achieved higher rates of return over the last few years. Furthermore, if we adjust for an annual inflation rate of 2%, these 9,000 euros will be worth 3,700 euros in terms of purchasing power, which is still almost four times your initial savings.

Now compare your situation with that of an older person who has only five more years to go until retirement. If this person invests 1,000 euros at an annual rate of 5%, he will end up with 1,300 euros. We could also look at it another way. How much would this person have to save to end up with 9,000 euros? Rather a lot of money – slightly over 7,000 euros. What these calculations help us understand is that saving for retirement can be quite profitable for young people. After all, time is on their side. What we see here is the power of compound interest at work

Research shows that many (young) people will not save for their old-age pensions if it is left up to them. Why is that? There are several explanations for this. One explanation is that people simply like living in the here and now, because it gives them something to hold on to. Since the future is insecure by definition, people tend not to look beyond the short term. What this means is that current euros are preferred to future euros. That is, people have a time preference: they do not want to trade their current money for future money. Another explanation is that people do not like taking risks, as this will result in fluctuations in their pension wealth. Indeed, research shows that despite the relatively high average rates of return on risky investments, most people are not willing to invest in stocks. Economists call this the stock market participation puzzle.

In the Netherlands, the social partners and the government have agreed to reform the current pension system, because employers are finding the current system rather expensive. Questions that are being raised include: Should we give people the freedom to withdraw money at any time from their pension accounts? Should we let people choose their own investment portfolios? Considering the above arguments regarding people’s time preference and aversion to taking risks, the answer to these questions should probably be no.